Participatory Notes: Regulating Complex Financial Instruments

Today’s Mint carries a column by Niranjan Rajadhyaksha that deals with the issues relating to regulation of complex financial instruments such as participatory notes that are held by investors like hedge funds. Referring to the classic debate between public regulation and market regulation, he states:

“Regulators have two options: to demand more clarity on what is going on or to clamp down on financial innovation. The former is quite clearly the more sensible option. Bans never help, although there are the inevitable calls for them whenever there are problems in the financial markets. Usually, crises in the real economy bring with them calls for further deregulation while crises in the financial economy come with calls for tighter regulation: That’s a big paradox in the annals of contemporary policy debate.

All this is of relevance to India. The domestic financial markets are still repressed. Local investors have access to a limited range of securities to buy and sell. But the same cannot be said of offshore investors who are taking positions on the Indian economy—either directly or indirectly. Many of them are hedge funds who use a range of trading strategies. They buy into the India story through participatory notes (PNs), which are offshore instruments backed by Indian equities and derivatives and whose proliferation has kept troubling the Reserve Bank of India and the Securities And Exchange Board of India (Sebi).”

He also cites an IMF Working Paper by Manmohan Singh that traces the use of participatory notes in the Indian financial markets, and concludes with the impact of the regulatory pronouncements issued by SEBI in October 2007. The abstract of the paper runs as follows:

“This paper focuses on the use of participatory notes (PNs) by foreign investors, as a conduit for portfolio flows into Indian equity markets for more than a decade. The broadening of India’s foreign investor base, in recent years, has a bias towards hedge funds/unregistered foreign investors who invest primarily via PNs. While tax arbitrage via capital gains tax has almost disappeared since July 2004, it is intriguing to note that since then the demand for PNs has actually increased. The paper suggests some reasons for the continuation of a buoyant market in PNs, and explains the possible impact from the recent regulatory changes.”

SEBI’s October 2007 pronouncements can be found here and here. Essentially, they bar foreign institutional investors (FIIs) from issuing PNs on derivatives and require them to wind-down their existing positions within 18 months. As far as PNs for cash are concerned, they are permitted up to a maximum of 40% of the assets under custody (AUC) of the FIIs.

Manmohan Singh concludes as follows:

“SEBI’s ban on the issuance of PNs on derivatives will reshuffle the investor base on portfolio inflows. Its proposal may increase the inflows onshore by the apparent interest from real money accounts to register onshore (including pension, endowments, charitable trusts etc); however, inflows from margin accounts (i.e., from investors who use PNs on derivatives) are likely to disappear along with some investors from the PN cash market. Inflows from PNs on derivatives will not be replaced since this route allowed transactions that cannot be mimicked onshore. The near-term impact depends on how staggered the unwinding is likely to be. Once the reshuffling of the investor base in favor of the real money account takes place over the next 18 months, capital flows are likely to be more stable.”

Although SEBI’s pronouncements are likely to cause churn in FII investments during the 18-month period and possibly disrupt investment flows, the regulator’s action is a unique step toward investor regulation and enhanced transparency. While economies like the US are still grappling with the issue of whether to regulate hedge funds and other similar investors, India has taken the step of imposing stringent regulations by requiring hedge funds and other PN holders to register directly with SEBI rather than use conduits such as PNs to avoid registration requirements.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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